Fixed-income investing often takes a backseat in our thoughts to the fast-paced stock market, with its daily action and promises of superior
returns, but if you're a retired investor, or are approaching retirement, fixed-income investing must move into the driver's seat. At this stage, preservation of
capital with a guaranteed income stream becomes the most important goal. In today's ultra-low interest-rate world, fixed-income investing has become much more complex, and gone are the days where one could invest in
U.S. Treasuries at 8%, sit back, and let the income roll in.
Today, investors need to mix things up and get exposure to different asset classes to keep their portfolio incomes high, reduce risk and stay ahead of
inflation. Even the great Benjamin Graham, the father of
value investing, suggested a portfolio mix of stocks and bonds for later-stage investors. If he were alive today, he would probably sing the same tune, especially since the advent of new and diverse products and strategies for income-seeking investors. In this article, we'll lay down the road map for creating a modern fixed-income portfolio. (To find more information on retirement planning as you age, see
Preparing To Tap Your Income Stream,
Retirement Saving Tips For 45- To 54-Year-Olds,
55- To 64-Year-Olds and
65-Year-Olds And Over.)
Some Historical Perspective
From the very beginning, we are taught that stock returns outpace returns from bonds. While this has been shown to be true, the discrepancy between the two returns is not as great as one might think. The
Journal of American Finance conducted a study, "Long Term Bonds Vs. Stocks" (2004). Using more than 60 staggered 35-year intervals from 1900-1996, the study showed that stock returns, after inflation was accounted for, measured an increase of about 5.5%. Bonds, on the other hand, showed
real returns (after inflation) of roughly 3%.
The Long Bond in the Rearview Mirror
One of the most important changes to fixed-income investing in the 1990s and 2000s era is that the
long bond (a bond maturing in more than 10 years) has given up its previously substantial yield benefit. (To learn how inflation affects long bonds, see
The Forgotten Problem Of Inflation,
Curbing The Effects Of Inflation and
All About Inflation.)
For example, take a look at the yield curves for the major bond classes as they stood on November 15, 2006:
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| Figure 1 |
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| Figure 2 |
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| Figure 3 |
There are several conclusions that can be reached from a review of these charts:
With short-term yields so close to those of long-term yields, it simply doesn't make sense to commit to the long bond anymore. Locking up your money for another 20 years to gain a paltry extra 20 or 30 basis points just doesn't pay enough to make the investment worthwhile.
This presents an opportunity for fixed-income investors, because purchases can be made in the five- to 10-year maturity range, then reinvested at prevailing rates when those bonds come due. When these bonds
mature is also a natural time to reassess the state of the economy and adjust your portfolio as needed.
The current relationship between short-term and long-term yields also illustrates the utility of a
bond ladder. Laddering means investing in eight to 10 individual issues, with one coming due every year. This can prevent you from having to forecast interest rates into the future, as maturities will be spread out over the yield curve, with opportunities to readjust every year as your visibility gets clearer. (To read more about bond ladders, see
The Basics Of The Bond Ladder.)
Add Spice to Your Portfolio
1. Equities
Adding some solid, high-dividend paying
equities to form a balanced portfolio is becoming a valuable new model for late-stage investing, even for folks well into their retirement years. There are plenty of large, established companies in the
S&P 500 that pay yields in excess of current inflation rates (which are running at about 2.5% per year), along with the added benefit of allowing an investor to participate in corporate profit growth. (To find more information on how to balance your portfolio, read
Rebalance Your Portfolio To Stay On Track,
Modern Portfolio Theory: An Overview and
Revive Your Portfolio.)
A simple
stock screener can be used to find companies that offer high dividend payouts while also meeting certain value and stability requirements, such as those fit for a conservative investor seeking to minimize
idiosyncratic (stock-specific) and market risks. Below is a list of companies with the following example screen criteria:
- Size - At least $10 billion in market capitalization
- High Dividends - All pay a yield of at least 2.8%
- Low Volatility - All stocks have a beta of less than 1, which means they have traded with less volatility than the overall market.
- Reasonable Valuations - All stocks have a P/E to growth ratio, or PEG ratio of 1.75 or less, which means that growth expectations are reasonably priced into the stock. This filter removes companies whose dividends are artificially high due to deteriorating earnings fundamentals.
- Sector Diversification - The chart below contains companies within all of the major sectors of the S&P 500. A basket of stocks from different sectors can minimize certain market risks by investing in all parts of the economy.
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| Source: Yahoo! Finance |
| Figure 4: Average Yield = 3.25% |
To be certain, investing in equities comes with considerable risks compared with fixed income, but these risks can be mitigated by diversifying within sectors and keeping overall equity exposure below 30-40% of the total portfolio value.
Any myths about high-dividend stocks being stodgy, non-performers are just that - myths. Consider that between 1972 and 2005, stocks in the S&P that paid dividends paid a return of over 10% per year annualized, compared with only 4.3% over the same period for stocks that did not pay dividends. Steady amounts of cash income, lower volatility and higher returns? They aren't sounding so stodgy anymore, are they?
2. Real Estate
Real estate investment trusts (REITs) are another way to get some high-yielding securities in a conservative portfolio. They provide liquidity, trade like stocks and also have the added benefit of being a distinct asset from bonds and equities. REITs are a way to diversify our modern fixed-income portfolio against market risks in stocks and
credit risks in bonds. (For more on this investment vehicle, check out
The REIT Way and
What Are REITs?)
3. High Yield Bonds
High yield bonds are another potential avenue. The so-called "
junk bonds" that offer above-market yields are very difficult to invest in individually with confidence, but by choosing a fund with consistent operating results, you can devote a portion of your portfolio to high-yield bond issues as a way to boost fixed income returns. (To read more, see
Junk Bonds: Everything You Need To Know.)
Many high-yield funds will be
closed-end, which means that the price may trade higher than the
net asset value (NAV) of the fund. Look to find a fund with little to no premium over the NAV for an extra margin of safety when investing here.
4. Inflation-Protected Securities
Next, consider
Treasury Inflation-Protected Securities (TIPS). They are a great way to protect against whatever inflation might throw your way in the future. They carry a modest coupon rate (usually between 1 and 2.5%), but the real benefit is that the price will be adjusted systematically to keep pace with inflation.
It is important to note that TIPS are best held in non-taxable accounts, as the inflation adjustments are made through additions to the
principal amount. This means that they could create large
capital gains when sold, so keep the TIPS in that IRA, and you'll be adding some solid inflation-fighting punch with the security that only U.S. Treasuries can provide.
5. Emerging Market Debt
Much like with high-yield issues, emerging market debt is best invested in via a mutual fund or
exchange-traded fund (ETF). Individual issues can be illiquid and hard to research effectively. But yields have historically been higher than advanced economy debt, and provide a nice diversification from country-specific risks. Like with high-yield funds, many emerging market funds are closed-end, so look for ones that are reasonably priced compared to their NAV.
A Sample Portfolio
This sample portfolio would provide valuable exposure to other markets and asset classes. The portfolio below (Figure 5) was created with safety in mind, but is also poised to participate in global growth through investments in equities and real estate assets.
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| Figure 5 |
A Note on Risk
There are risks associated with each type of investment listed here. Diversification among asset classes, however, has proved to be a very effective way to reduce overall portfolio risk. The biggest danger to an investor seeking principal protection with income is keeping pace with inflation, and a savvy way to reduce this risk is by diversifying among high quality, higher-yielding investments more than standard bonds.
Know When To Ask For Help
If it turns out that an investor's retirement plan will call for a periodic "
drawing down" of the principal amounts as well as receiving the cash flows, it is best to visit a
certified financial plannerä (CFP
ä), who can assist with both the investing and accounting side of a retirement plan, since the size of the portfolio will need to be measured carefully to determine the optimal level of cash flows, and maximizing tax savings will be crucial. A CFP can also run
Monte Carlo simulations to show you how a given portfolio would react to different economic environments, changes in interest rates and other potential factors. (To read more about risk and the Monte Carlo model, see
Monte Carlo Simulation With GBM,
Introduction to Value at Risk (VAR) - Part 1 and
Part 2.)
We Live in a World of Funds
There are fund options available for any investment method described here, and deciding whether to use one will come down to how much time and effort an investor wishes to devote to his or her portfolio. Choosing wisely is important here, because fees become crucial at this level - a fund aiming to throw off 5% per year in income or dividends is giving up a big slice of an already small pie with an expense ratio of even 0.5%. So keep an eye out for funds with long track records, low turnover and, above all else, low fees when traveling this route.
Conclusion
Fixed income investing has changed dramatically in just a short period of time. While some aspects have become trickier, Wall Street has responded by providing more tools for the modern fixed income investor to create custom portfolios. Being a successful fixed income investor today just might mean going outside the classical style boxes and using these tools to create a modern fixed income portfolio, one that is fit and flexible in an uncertain world.
by Ryan Barnes, (Contact Author | Biography)
Ryan Barnes has over 10 years experience in portfolio management and investment research, covering equities, fixed income and derivative products. Barnes has worked with Merrill Lynch, Charles Schwab, Morgan Stanley and many others as an institutional trader, and maintained AIMR compliant performance for a diverse set of high-net-worth investors.
Barnes is currently working as a writer and financial modeling consultant specializing in capital appreciation and hedging strategies, and is the editor of EpiphanyInvesting, a website devoted to finding long-term success in the stock market.
